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Wednesday, April 6, 2016

The Essential Retirement Guide: A Contrarian’s Perspective

We all hear the steady drumbeat of fear-mongering about a retirement crisis and how we need to save more for retirement. Actuary Frederick Vettese aims to be a voice of reason with his book The Essential Retirement Guide: A Contrarian’s Perspective. He says we’re not nearly as badly off as banks and insurance companies would have us believe.

I learned quite a bit about a wide range of financial aspects of retirement from this book. One example is that long-term care insurance is a bad deal for almost everyone. Another is the frightening fact that as we age our ability to manage our finances deteriorates, but our confidence in our abilities increases. So, we’re unlikely to seek help when we most need it. There were also some important parts of the book I disagreed with.

Vettese begins the Preface pointing a U.S. study showing that 88% of people over 85 have some financial or housing assets. He presents this as evidence that people are doing reasonably well in their retirements. I looked up the study and found that while 12% had no assets at all, another 11% had less than $10,000. So, nearly one-quarter of the elderly have almost nothing. That doesn’t sound overly positive to me.

The early chapters make a very strong case that the usual rule of thumb that you need 70% as much income in retirement as you had while working is just too high for those with above-average incomes. I know this applies to me. I won’t need anywhere near 70% of my current income when I retire.

People with very low incomes may need nearly 100% of their incomes in retirement, but that will be covered by CPP/OAS/GIS. For people with higher incomes, Vettese explains that an income target of 50% is more realistic to maintain the same standard of living heading into retirement.

When it comes to choosing a wealth target you’ll need before retiring, Vettese asks “if the wealth target were higher than the cost of an annuity, then why take the risk of managing your own money?” The answer that he seems to miss is inflation risk. The short-term risk of inflation running up seems small, but are you prepared to gamble that it will never happen for the rest of your life? Insurance companies don’t like offering inflation-indexed annuities because “inflation might take off again.” Why should we ignore this risk?

Underpinning Vettese’s calculations of how much money you need to retire is his belief that because people spend less as they age, we can assume that retirement spending “does not have to be indexed to inflation.” In a previous article I explained why we should assume a much smaller spending decline than the amount of inflation. It’s hard to tell how big a reduction in spending over decades of retirement is actually baked into his calculations. This is because CPP and OAS are indexed, and one of the notes in the Appendices seems to imply that he included some indexing in the annuity calculations.

“By eliminating unhealthy behaviors,” such as smoking, drinking, eating poorly, inactivity, and being stressed, “you can restore 7.5 years of lost life expectancy.” The remarkable part of this is that “you can gain back up to 9.8 years of healthy life expectancy.” So, living a healthy life leads to a longer life but actually cuts down on the number of unhealthy years you’re likely to live.

In a chapter on savings rates, Vettese makes a good case that your average saving rate doesn’t have to be as high as you might think. I think they have to be a little higher than he says because it doesn’t make sense to ignore inflation in retirement. However, there is another reason to pick a higher savings rate. For a young person starting out, there are likely to be good and bad times financially. You have to save more during the good times because your savings rate will drop or even go negative in bad times.

The author makes some predictions that seem to make sense. He says that interest rates will stay low for a long time mainly because of demographics. Large numbers of people getting older are driving the demand for bonds. Another prediction concerns annuities. He says the trend away from defined-benefit pension plans is causing plan sponsors to buy annuities to de-risk these plans. He says it will take about 5 years for annuity demand to drop off and for annuity prices to fall.

In a chapter called “Carpe Diem,” Vettese argues that your 60s are the best time to take advantage of your health and spend some money doing fun things while you can. He points out the health problems that will come later and the pressures that dominate earlier decades of life. Not coincidentally, he’s in his early 60s himself. I think a 50-year old could easily make the same case for spending in one’s 50s. The same applies to people in their 40s, 30s, and 20s. I see this chapter as little more than trying to justify spending today. The truth is that we need balanced spending across all ages. No one age should be favoured. And at any age, we should be looking for ways to enjoy life that don’t take a lot of money.

Overall, I’m glad I read this book. Even though I disagreed with some parts, it gave me some new and useful ways of thinking about retirement. I recommend it mainly to people with above average incomes who have no defined benefit pensions.

7 comments:

I think when compared to income ranges, this should come as no surprise. And economic mobility can work in both directions. A long-term trend of zero-asset seniors might give a more useful picture of the situation. (I'm too lazy to look for that info)

"Insurance companies don’t like offering inflation-indexed annuities because “inflation might take off again.” Why should we ignore this risk?"

Is it possible to buy/construct an annuity ladder to mimic inflation? Or just easier/cheaper to utilize other financial tools to do the same?

"Another is the frightening fact that as we age our ability to manage our finances deteriorates"

I know little about annuities but the above is one recurring argument I hear in support of them. A wise move?

@SST: Thanks. I'm not surprised that many U.S. seniors have no assets, but I'm not the one taking it as a sign that all is well among seniors.

You can buy an annuity with fixed-rate indexing such as payments rising 2% each year. However, the starting payments will be lower, and few people make this sensible choice. Whether an annuity is better than other options depends greatly on the annuity's payout.

Possible cognitive impairment certainly argues in favour of buying an annuity. Whether it is wise is all in the payout numbers.

What are the drawbacks of simply maintaining a simple indexing couch potato strategy in retirement? Maybe just adjusting your asset mixes? Why does that not work then as well? That way the amount of thought involved is minimal. Sure there are some years with volatility, but in the grand scheme it still is a sound strategy.

@Paul: The main drawback is that you'll have to be conservative with spending in case you live to be very old. With an annuity, if you have a long life, you'll actually get paid more than you paid for it.

This advantage of an annuity has to be balanced against the fact that it is essentially a fixed-income investment with some baked-in fees.

@MJ - Pardon my idgnorance, but what fees are baked into annuities? I was under the impression that the insurance agent gets a one-time commission, but thought annuities weren't too bad otherwise in terms of fees when compared to some other alternatives. Curious to hear your assessment. Great blog. Cheers.

@Juan: Simple annuities are fixed income products similar to bonds. Rather than charge an explicit fee to cover commissions, other costs, and desired profits, insurance companies just bake these amounts into the annuity's payout.